Table of Contents
CFA Level 2 – Equity, Session 12-Reading 45, Residual Income Valuation-LOS e
(Practice Questions, Sample Questions)
1. In a single-stage residual income model for a firm with return on equity (ROE) greater than the required rate of return, which statement is least accurate?
A) Market value will be greater than book value.
B) The justified price-to-book value (P/B) ratio will be greater than one.
C) Free cash flow to equity will be positive. [In a single-stage residual income model with ROE greater than the required rate of return, justified P/B will be greater than one and market value will be greater than book. There is no clear relationship with free cash flow to equity]
2. Among the various price multiples, the residual income model is most closely linked to which of the following?
A) Price to book value (P/B). [The residual income model is most closely linked to P/B because justified P/B is directly linked to expected residual future income]
B) Price to free cash flow (P/FCF).
C) Price to earnings (P/E)
3. Assuming that the growth rate is less than the required rate of return (r), a decrease in initial book value will cause value in a residual income (RI) model to:
A) decrease. [A decrease (increase) in initial book value decreases (increases) value. This is revealed by the RI valuation expression: V0 = B0 + [(ROE – r) / (r – g)]B0]
B) increase.
C) there is insufficient information to determine the effect on RI
